This will be a short personal finance post. There is an odd series of claims made in the ongoing debate about the merit of home ownership in the personal finance community. Some very famous financial personalities/authors have said rather controversial things about buying a home. Among these takes are: “your house is not an asset,” “your house is a liability,” “renting will make you rich,” and “all debt is evil.”
A lot of these statements can probably be partially excused as attempts to have a “hot take” to shock readers into undertaking a critical examination of the conventional wisdom that owning a home, rather than renting, is a no brainer or “the best way to build wealth.” Similarly, the slogans in favor of buying homes are also probably attempts to shock people into the (huge) action of buying a home. So what is the right answer?
Perhaps, unsurprisingly, blanket rules and hot takes leave a little to be desired when you are determining how to run your financial life. Depending on the facts at play, owner-occupied personal residences are usually a pretty great financial idea.
If you are comparing buying a “dream-home” mansion versus renting a studio apartment in a third tier city, however, the buy decision is not going to come out better from an economic perspective.
In some markets, the speculative fervor for housing can cause prices to own to far exceed the relative cost of renting (though that doesn’t seem to make a lot of sense in the long-run, absent non-economic supply constraints). This might be the case in big Canadian cities or in the Bay Area of San Francisco.
But if you are comparing like for like properties (or something akin thereto) and you are not in a “hot” market, buying you own home is probably a good investment. The trick, like any investment, is probably going to be analyzing the returns and risks on offer in a particular case.
Don’t be Daft, Of course a Home is an Asset
One thing that can be said with some certainty, is that both renting and buying provide you with assets (and attendant liabilities). When you lease a residence you are acquiring a limited time interest (right to possession) of the property. Let’s say you lease a home for 5 years. With this agreement, you acquire an interest in the underlying real property.
You paid money for possession and use of the property. You also purchased other rights. For example, you may be able to sublease the property to derive income/rent. You also accept some liabilities. For example, if you rented a beach house for two weeks and a hurricane comes along and wipes it off the face of the earth, you lost your leasehold asset (but maybe you have vacation insurance to reimburse you for the loss via your Chase Sapphire Preferred).
If you bought the same property you were considering leasing you would acquire this possession interest (i.e., the right to live there for the 5 year lease term) along with bundle of additional rights. In addition to the right to live there for 5 years, you have a bunch of other rights like the right to the residual value of the property after you terminate your residence there (or to live there in year 6 if you want).
When you decide to move you can try to sell the remaining rights to the home. Some other rights you might have include mineral rights if oil is discovered on the property. Maybe air rights if someone wants to build a huge office tower over your property. Maybe you sell the surface rights but retain the mineral rights if you live in Texas or Oklahoma or something.
Anyway, assets are acquired either way: pursuant to a lease agreement or a deed in fee simple. They both also come along with liabilities. Rent payments are an obvious liability that attaches to the lease. You also might have to maintain aspects of the property or lawn. You might be liable if you invite a guest over and he destroys a wall in the home.
Similarly, if you bought the same home, the property would come with liabilities, such as property taxes, and/or the requirement to maintain the lawn/grounds in accordance with municipal requirements (or maybe a private governing body like an HOA).
Typical residential leases do allocate the liability for major capital expenditures and maintenance with the lessor/owner of the property. These costs are generally going to be factored into rental rates charged by these landlords (for example, all else being equal, a triple-net commercial lease where the landlord has almost no obligations to maintain the property, are usually going to require lower rent than a lease where the landlord retains more management requirements). Landlords definitely evaluate the potential and actual capital expenditures when evaluating rental properties and adjust their prices paid and rents charged accordingly (as the market allows).
So, whether you rent or lease a home you are acquiring an “asset.” This asset is going to come with some liabilities in either case. I suppose when commentators say “your house is a liability” or “a lease is throwing money away,” what they are really saying is “I’m going to highlight this relative pro or con of the respective real estate interest, with a hot-take.”
But, which asset is more likely to be the better financial decision?
Punting the Question to Others
I think the answer is: “it depends.” What if you were analyzing whether to rent (for a term of 5 years) or buy the exact same property? You could rent the property for $20 for 5 years (bear with me, lawyers and math) or buy the property for $100 and sell it after 5 years for $80. If all other rights (and liabilities) were the same, it would be a push (basically).
Either way you are spending $20 to possess the property for 5 years and your return on your $100 investment to purchase that property was the foregone rent (or the use of the housing). Given this foregone (or implied) rent it seems the hot take of “your home doesn’t produce income” is not really right either.
But how realistic is this example? Probably not very.
In reality, one big difference between the two options is transaction costs. Transaction costs to buy real estate are usually much higher than to enter a residential lease (theft of tenant deposits aside). Renting typically doesn’t require big realtor fees (though in NYC brokers can take a pretty big fee for leases) and the legal documentation and transfer taxes are cheaper.
On the other hand buyers also will likely receive increases in the value of their interests in the purchased home. This will probably be from both increases in avoided rent over time and increases in value of selling the remainder interest in their home.
Housing prices in the U.S. have typically appreciated. Most of the data indicates that this has been only a little more than general inflation. In addition to the inflation in the residual price of homes, the rent of primary residences has increased a little greater than the general inflation rate since 1984.
Lessors avoid the inflation/increases in rent only pursuant to the terms of their lease (which could have annual escalators or something). At the end of the lease, the rent is probably going up.
So both the residual value and the implied yield from owning a home seem to have historically (in the U.S. broadly) increased at a rate that modestly exceeded inflation (the data is kind of crappy, but this result also makes sense given the size of the asset class, its role in society and the economy, etc…).
The champions of renting will point out that this is not great performance (especially in comparison with stocks). However, you don’t have to pay for 100% of a purchase home with equity (i.e., you cash that would otherwise be used to purchase stonks). In fact, you can get super-duper special, fixed rate, government-subsidized, debt with a one way option in case rates/inflation drop (i.e., you can prepay and refinance with no penalty).
So, assuming a good decision on the purchase (i.e., you didn’t buy too much house or in an overheated market where your implied rent yield sucks) you can get some positive, inflation-favored leverage going in your favor.
The fixed rate mortgage also gives you something like an option on general inflation. If things tank and we head into a deflationary environment (like 2020), then rates will likely crater to reflect inflation expectations and you can refinance and lock in a lower rate. If inflation and rental yields and real estate prices all explode up at 7% per year, you can ride with your 30 year fixed rate 3% nominal mortgage for a few decades while paying a -4% real yield.
Anyhow, I am boring myself with this minutiae. If I have to distill down the analysis I would say: 1) if you don’t buy too much house (versus what you would rent); and 2) only buy if you are going to be settled for a while (to defray those huge transaction costs to buy and sell houses and also so you get to enjoy avoiding that rental and real estate inflation while you are frozen in time for most of your costs); and 3) lever the thing smartly (there is no other way I, as a retail piker, can get 30 year fixed rate debt that has a one-way refinance option and allows me to lever an asset 5x!!!), then your purchase has a great chance of turning out well.
So, if we just don’t do anything stupid and we get a little real estate price and rental inflation/appreciate a home will probably be a great investment.
Evaluating the ROA on Your Home purchase
A more detailed answer might be to evaluate the potential purchase of a home as if you were going to buy it and rent to someone else. Then if the returns are lower than what you would accept in that scenario, that might be fine but it probably represents more consumption than investment (i.e., I decide I want to spend on a nicer place to live than I would be willing to buy as an investor so my net worth overall is going to be lower). Even if you make this decision to be a little spendy, you’ve still got a chance that inflation and/or appreciation combined with leverage leave you with a nice return.
For a better treatment, complete with a spreadsheet where you can analyze assumptions on lease versus buy decisions, check out this post by Big ERN over at Early Retirement Now. He goes through the process of analyzing the home purchase just like you would a rental property investment. He also notes that your rent avoided is basically the same as rent received, from an economic perspective. So you use that in your analysis as the yield.
It is better to Avoid Rent Than to Receive?
Thinking through this as I write, I observe that the foregone rent is probably even better than rent you would receive from a rental investment property. I can think of two reasons why.
First, you will have no vacancy costs. When you own or evaluate a rent property you need to build in some costs/reduced revenues for vacancy. The home/unit is unlikely to be rented every month in perpetuity with no “downtime.” Tenants move out and you have to do stuff to release the property. As I understand it, that is usually not instant.
Assuming you are not moving back in with mommy, and have to live somewhere every month of your life. If you own a home, you are avoiding the rent you would otherwise pay every single month. There is no time off for move outs rehabilitation and re-leasing. So there should be zero vacancy costs/allowances. That would be a rare and beautiful thing in a rental investment property.
Second, if you are avoiding an expense, you are getting basically a dollar for dollar increase to wealth. Unlike most forms of earnings or income, reduced expenses don’t come with attendant fees or taxes. Simply stated: A dollar saved is worth more than a dollar earned.
So, when comparing the decision on a home purchase to a rental property investment, you’re not going to have to pay any taxes or fees for the implied rent earned from for the purchased property.
Granted, you will have other expenses incident to owning the home which will factor in elsewhere in the analysis. In addition, many real estate investors claim not to pay any taxes (and, in truth, their burden is usually low), but they still have taxes and fees related to that rental income (even if they are just hiring accountants and lawyers to report and manage the liability). So for purposes of comparing the yields obtained from third-party rent versus avoided rent for an owner-occupied home, it seems the implied rent is going to [keep] more money in your pocket on an after tax and fees basis.
A Single Family Home is A Great Investment
Ok, not only did I enlist a much better blogger than me in making my point, I am now going to call in the big gun. While the (almost) never buy crowd can call out plenty of best selling authors and radio personalities to carry their banner, the buying advocates can cite none other than Warren E. Buffett.
You may have heard of him, he’s pretty good with money. Anyway, here’s a link to an interview with CNBC (from 2012) where they ask him,”Is a single family home is still a great investment?”
A single family home is still a great investment
That link should take you to about 1 hour and 2 minutes into the interview (in case something went awry).
Buffett went through many of the caveats that we have covered above (you need to settle in for a bit to recoup the big transaction costs and you need to try and avoid a financial squeeze by buying too much house or if your job isn’t very secure. Both of these allow inflation and appreciation to work for you).
So, he isn’t saying that it is a universal no brainer, but he concludes usually, investing in an (owner-occupied) single family home is a great investment. While he has not yet obtained his own syndicated talk radio show, the man does know a thing or two about what makes a great investment.
In conclusion, in most cases, buying a single family home to live in is a good financial idea. In any scenario, both buying and renting a home involve the acquisition of a real property interest (an asset) which comes with a set of attendant liabilities. I will try keep this in mind whenever I am “enjoying” the latest round of hot takes.